The Business Cycle: A Brief Introduction

My interest in economic theory stems from a desire to learn about what is commonly called the "business cycle". Since the beginnings of the "Subprime Crisis" in the housing market and the credit market problems that have become associated with the meltdown in many structured investment products I've tried to familiarize myself with what were the causes of these problems. Was it a fundamental, though necessary, defect inherent to capitalism? Was it government mismanagement as many free-market propenents are wont to blame? Does the crisis represent a need for more regulation and intervention by government?

Unfortunately I haven't determined precisely what were the causes of the recent economic crises. I became sidetracked reading about economic theory. I began by reading Schumpeter and became acquainted with his book Business Cycles: A Theoretical, Historical, and Statistical Analysis (though the abridged version). Schumpeter's book is a suberb history of capitalism. Starting at the beginnings of industrialization up to the early 20th century when the book was published, Schumpeter applies his theory of cyclical waves that are inherent to the capitalist system and are caused by how fast (or slow) new innovations are adopted by the system and how the effects of these innovations cause adaptations in surrounding industries.

The Schumpeterian theory does not coincide with what I found elsewhere, like in the work of von Mises, and the man who expounded upon the Misesian conception of the Business Cycle, F.A. von Hayek. In Prices and Production, Hayek argues that the cyclical fluctuations that have been experienced throughout the history of modern capitalism up to that point were not caused by anything inherent to the capitalist system, but instead were products of what Mises termed in his 1912 monetary treatise, "Fiduciary Media", ie. credit. Hayek's chief new contribution in the book was his insight into the stages of productions. After Bohm-Bawerk, Hayek and Mises combated a misconception found in the work of American economists F.H. Knight and John Bates Clark, where they argued that "capital" was a homegeneous fund, a flow of goods that is for all intents and purposes perpetual. The Austrians view "capital" as being heterogenous, with differing capital goods according to their relative specificities. Some elements of capital are relatively easy to transfer from industry to industry, but others, such as specific machinery equipment, are basically fixed in their employment in a specific industrial pursuit. Hayek also built upon Bohm-Bawerk's roundabout process of production by explaining that a longer period of production represents more capitalistic (capital intensive) methods of building and creating things.

According to the fiduciary media argument, the business cycle is caused by monetary inflation, this monetary inflation distorts economic calculation depending on where it is injected within the economic system. Typically, new money is introduced through the banking system, with the newly created funds appearing on the loan markets (because that is the main business of banks--to loan money) the rate of interest is artificially lowered below the "natural rate of interest". The Natural Rate is an insight credited to the Swedish economist Knut Wicksell, in which he explained that the natural rate is derived from the relative time preferences of individuals in society, reflected in how willing or unwilling they are to save money. More savings implies a lower natural rate of interest and, therefore, a lower time preference, and vice versa. If the rate of interest is artificially lowered below the natural rate, then the more capital intensive industries will mistakenly believe that it is now profitable (and it temporarily is) to construct more specific capital goods. A lower interest rate implies a lower time preference, which tells entrepreneurs that it is now potentially profitable to lengthen the period of production. For a while this will cause booms in the prices of many raw materials and other resources needed in the construction of this new plant equipment. Unfortunately, once the newly created money has worked its way upon the whole system through the payments of wages and spending habits of those recieving them, as well as through the purchases of the companies that recieved the new money, the interest rate will tend to rise toward the rate that was previously present before the inflation (though its rare for it to be precisely the same rate, for reasons too detailed to get into here). Since the time preference of those in society did not shift radically enough to justify the construction of much of the newly created capital goods, they are no longer as profitable as previously thought (if profitable at all), and this then calls for a liquidation of many of the enterprises that were created during the boom, with the more non-specific capital goods being shifted toward enterprises that are closer to consumption. The economic crisis that creates the notion of the "business cycle" is essentially this process of liquidation of pursuits that were altogether unsustainable, and these pursuits would not have been pursued had there been no monetary inflation in the economic system that served to distort the economic calculations of entreprenuers. Some capital is forever squandered and workers employed in the unsustainable enterprises must find new jobs. This is the view of Hayek and Mises.

This just touches the surface of the varying opinions about what causes the business cycle (I neglected to mention the Keynesian view). To be sure, there is much more worth investigating. In a later post I'll write about Mark Skousen's book The Structure of Production and what it says about the Business Cycle and the many theories that attempt to explain it.

What Is Seen and What Is Not Seen

Drake Bennett in the Boston Globe recently wrote an article arguing that natural disasters can help facilitate and sometimes embolden a country's drive for economic growth.

He argues,

Rebuilding efforts serve as a short-term boost by attracting resources to a
country, and the disasters themselves, by destroying old factories and old
roads, airports, and bridges, allow new and more efficient public and private
infrastructure to be built, forcing the transition to a sleeker, more productive
economy in the long term.

Aside from the often terrible after-effects of earthquakes, hurricanes, and tornados, Bennett disregards the fact that if it were not for the destruction caused by these events then the resources employed in reconstruction would instead be employed in some other pursuit. Natural disasters always result in the elimination of some resources. Bennett's view has already been proven fallacious by Frédéric Bastiat. Writing in 1848, Bastiat distinguished between What Is Seen and What Is Not Seen. In part 1, The Broken Window, he wrote that economic life is characterized by finite resources; all resources that are economic are essentially scarce, and the destruction of any of these limited resources can only make man poorer. This is true because more of the limited resources must now be used to replace what has been destroyed rather than be used to satisfy some other human need.

Bennett qualifies his view that natural disaster can be beneficial to the economy by saying that the recently eliminated resources can be replaced by more efficient and technologically superior methods, which then result in a less wasteful utilization of resources employed in any particular pursuit, ie. an older factory is leveled and replaced by a state-of-the-art factory. Although Bennett cites Schumpeter's concept of "Creative Destruction" he fails to recognize the role played by the entrepreneur in that "Creative Destruction"! Entrepreneurs determine when it is more or less profitable to replace older methods of production with newer, more techonologically up-to-date methods. Using the interest rate, they weigh the net present value of the expected earnings that would be generated from a more efficient mode of production against the net present value of the depreciating older capital stock. Once the value assigned to the former is larger than the latter, then older capital is replaced. There is a natural mechanism inherent to the capitalistic economy that determines when it is useful to replace older, less efficient modes of resource utilization with newer, more efficient modes. And this method is aligned with the demands of all consumers in the market economy (through the interest rate), rather than by the arbitrary effects of a natural disaster. Natural disasters do not result in economic growth, and any evidence to support such a claim is merely a trick of statistics.

Creative Destruction in NYC

Follow the link to see a bunch of older photos of NYC and a few of the surrounding boroughs. Some of the pictures go back as far as the 1880s. In my view, getting a glimpse of pre-WWI shots of the economic capital of the world is worth taking a peak in and of itself. The architectural achievements of the people, in a time that pre-dated the automobile, where horsedrawn carriages were the primary mode of transportion, and seemingly every man wore some sort of bowler hat, are all the more impressive and spectacular. The degree of building development that existed back then is truly a marvel once one considers the, from today's perspective, primitive state of techonological development that existed in pre-WWI society.

Also, as I made my way through the collection it was interesting to read some of the advertisements. Many companies were featured that remain in existence to this day, though many in a far less vibrant position than they were surely in during the time of the photographs. Coca-Cola, Chevrolet, Ford, and Macy's are all still present in the current business scene. But there are numerous other companies, and even select services, that I had no idea ever existed and have since disappeared from the production scene altogether. These photos are a great indicator of Joseph Schumpeter's notion of Creative Destruction, and its influence on the progressive removal and replacement of old firms, obsolete processes of production, out-dated cultural norms, and upsetting of old social hierarchies, in favor of new enterprises, more efficient and effective utilization of resources, and newly formed and realigned social classes.

Again, check it out.

Dec 30 1948

The American Economic Association hosted their yearly conference in my home town of Cleveland, Ohio in 1948. December 30th was the final day of the conference (a friday) that featured the organizer of that years agenda, Joseph Schumpeter, giving his closing speech on the state of, and overall role played by economics within the society at large. By all accounts this was a wonderful speech that left no economist--no matter the personal persuasion be they an adherent of Keynes or some other school--untouched, and all that witnessed this event firsthand attest that the lively Schumpeter was in top form.

Being from Cleveland and knowing of the diligence that is so typically characteristic of the Plain Dealer, I set out to dig up their coverage of this speech in our library's stash of microfilm. In the paper published on Dec 30th they do have a few paragraphs featuring comments from Schumpeter's colleague at Harvard Seymour Harris on inflation, and they also highlight Fritz Machlup's warning to economists not to grow disheartened at the slow transmission of intellectual ideas to the voting public at large that is so characteristic of the democratic political system. Machlup was speaking from experience as he witnessed firsthand the experiences of Europe in the early 20th century. But this days paper covered the events of the previous day. So I scoured the December 31st and January 1st editions of the paper while finding nothing on Schumpeter or his rousing speech. How can this be? How can there be not even a tiny article detailing the events when one of the most eminent economists of the day happen to be in your town? And at this time his eminence was surely recognized, many contemporary accounts indicate Schumpeter was regarded as perhaps the most famous economist in the world at the time. Though I may have missed a snippet on Dr. Schumpeter, he may have been mentioned inconspicuously, it remains a disappointment that a larger article could not have been devoted to a subject as pertinent and influential as that which Schumpeter spoke about.

It is disappointing that in a paper that dedicated large amounts of space to the business and politics of the day (perhaps more so than today even) there was no space provided for commentary on Schumpeter the man, what he meant to the study of society and economics, and the overall lessons of his speech.